The carry trade is an enigma in the financial world. When experts attempt to explain its continued profitability using traditional risk factors, they fail miserably. Sergio Rebelo and his fellow researchers have discovered a new way to minimize the risk posed by the unpredictable

By Tim De Chant

Economic theory has been predicting the collapse of the carry trade for some time now, but the widespread currency-based strategy continues to pad balance sheets with profit.

The carry trade works by borrowing money in low-interest-rate currencies and then lending it in high-interest-rate ones. Investors pocket the difference as profit. Theory says the two exchange rates should adjust as more people exploit the interest rate differential, eliminating the profit potential. But the carry trade remains a successful staple for hedge funds and other investors.

It sounds like a perfect strategy — almost too perfect. Behind the carry trade profits lurks a nagging question: Where does the money come from?

When experts attempt to explain the carry trade's profitability using traditional risk factors, they fail miserably. "Peso events," another possibility, has long been considered untestable. These rare upheavals in the market can wipe out gains. Higher interest rates in the lent currency may be the payoff for bearing such risks.

Sergio Rebelo, the Tokai Bank Professor of International Finance; Isaac Kleshchelski, an assistant professor of finance at Washington University (and 2008 Kellogg PhD); Martin Eichenbaum, the Ethel and John Lindgren Professor of Economics at Northwestern University; and Duke University Economics Professor Craig Burnside collected monthly exchange rate data for 20 different currencies between January 1976 and January 2008. They assembled a variety of carry trade portfolios, hoping to probe the role of peso events in the carry trade.

The carry trade is often described as "picking up pennies in front of a truck," according to Rebelo. Let's say you borrow one U.S. dollar at the current interest rate of 0.25 percent, convert it into Australian dollars, and lend the money at Australia's current 3 percent rate. Later, you can take the Australian dollars, convert them back, pay off your loan and pocket the difference. Congratulations, you made 2.75 cents, not accounting for transaction costs. The returns seem pitiful, but because you are using borrowed money, you could bet billions without using any of your own money. The profits appear sound and ripe for the picking, if not for the possibility of a peso event.

The term "peso event" originated in the 1970s. Mexico's national debt, its continued inflation, and falling oil prices were hammering its economy. Despite the peso's peg to the U.S. dollar, Mexican interest rates remained higher. Investors reaped steady profits until markets opened on Sept. 1, 1976, when the peso was allowed to float against the dollar. Its value plummeted more than 50 percent in one day, and many people suffered tremendous losses.

Predicting the daily ebbs and flows — or cliffs and crevasses — of the foreign exchange market is still fraught with uncertainty. Some of the mock portfolios Rebelo and his colleagues assembled were hedged with options — insurance plans that limit losses but can quickly eat into profits during stable markets. During simulated peso events, the unhedged portfolios lost much more money than the hedged positions, confirming the "peso problem" hypothesis.

But another mystery remained. Buying options merely skimmed off the top in good times and all but eliminated gut-wrenching losses during peso events. If the options had appropriately priced the risk associated with the peso problem, the cost of that insurance should have whittled away most of the profit. To the hedge-fund managers, the answer is clear: The options are too cheap.